Desirability of Quota Share vs. CAT bonds

[Packer16]

Had a question for our insurance gurus.  I have heard from some folks that investing in quota share can prevent some return erosion that may occur in investing in CAT bonds?  Is this true?  TIA.

 

Packer

[Cigarbutt]

Not a guru but have followed the ILS market with a lot of interest.

 

By prevention of return erosion, I assume you mean a different return profile. My understanding is that this conclusion is statistically correct. But everything is relative.

 

The expected return of CAT bonds is uncorrelated with financial markets, is skewed with a peak corresponding to a coupon-like return but there is a small tail tied to low probability catastrophe exposure. CAT bonds are based on an excess of loss insurance mechanism with triggers.

 

Sidecars which are typically based on a quota-share mechanism are more equity-like (of the related insurer/reinsurer) as a specific part of the exposed portfolio liability is exchanged for associated gross premiums. Quota-share type contracts make more sense if you think that the underwriting will be favorable or in a hard market although this conclusion does not seem to apply anymore as abundant capital seems to be chasing yield opportunities.

 

[Pondside47]

Do you know what specific factors could potentially cause the return erosion when investing in CAT bonds? I'm in the P/C industry and I'm drawing a blank so far. My understanding is you could lose your entire investments in either quota share notes or CAT bonds. Quota share is less transparent than event linked CAT bond, so you rely more on the person bringing you the opportunity (the sponsor I guess). I'm not a reinsurance specialist but I can certainly ask around for you with more context.

[Cigarbutt]

Additional thoughts:

 

-The tiered structure with tranches found in CAT bonds results in some variation of the risk/return profile and even if a collateralized quota-share hybrid transaction is not a tiered structure, the capital can be funded with debt (quota share notes) or equity. Holding the notes versus the equity would result in a less equity-type risk/return profile and more in a fixed income risk/return profile, maybe relatively comparable to some tranches of the CAT bonds but without the tail catastrophe risk.

 

-A variable potentially mitigating lower results in CAT bonds in certain years is the fact that collateralized quota-share contracts or sidecars are relatively flexible, in terms of composition, and can rest on premiums being derived from a more diversified book of business (property catastrophe, marine risks or even "bundled") versus a narrowly defined peril.

 

-In terms of return, CAT bonds are typically multi-year arrangements with the spread determined at the inception of the contract. In the event of a hard market not caused by CAT events or not associated with triggers tied to CAT bonds held, the relative value of CAT bonds in the portfolio would decrease in comparison to newer contracts reflecting higher rates for the remaining of the term. With collateralized quota-share contracts, which are typically potentially renewed every year, the return going forward would adjust to higher rates.

 

-I played with some numbers and tried to compare (retrospectively) the return that would have been obtained from a combination of CAT and quota-share contracts versus a basket of reinsurers. Interestingly, for different time periods, the former seemed to be doing better for many time periods. Going forward, it seems that the CAT bond yields are quite compressed (coupon or excess spread to expected loss is historically very low) and the "novelty" premium appears to be gone. Also, even accounting for the high 2017 catastrophe year, it has been relatively quiet on the catastrophe front for quite some time. Add to that the unusually long soft environment. Some suggest that ILS spreads are low because the risk is better understood but many are reaching for yield and loss model uncertainty always appears after large events.

 

I understand that many institutions like the field now because of the uncorrelated aspect of the academic risk but it can also be an opportunistic pure-play.

 

For these opportunities, I've always thought that it's better to invest when there is blood in the streets, not when it's raining dollar bills.